The Debt Settlement Trap

The Debt Settlement Trap

As a bankruptcy attorney, I talk with people every day about their debts. Many of my clients are very hesitant about filing bankruptcy. I understand their concern. It is a very big decision. By taking that step many people feel that they have failed or that they are doing something bad. I try to reassure them that filing bankruptcy doesn’t make them a bad person, but for most of the people I meet with bankruptcy is their last resort and consequently they inevitably will ask me about their other options, such as debt settlement.

Debt settlement may be a good option for some debtors but usually by the time a person end up in my office it is no longer an option. The credit cards are out of control or the mortgage is too far in arrears to save the home by a repayment plan. There are also a lot of companies marketing to debtors the virtues of debt settlement. These advertisements rarely explain the negative aspects of this course of action.

Debt settlement doesn’t usually average that a debtor pays a small fraction of the principal to satisfy the creditor’s claim. Debts are usually settled for lump sums that are nevertheless substantial amounts. What the creditor doesn’t explain is that at the end of the year the forgiven portion of the debt is reported to the Internal Revenue Service as income and the debtor pays taxes on it, so in the end there is very little net savings.

Taxes aren’t the only problem though. Creditors offering debt settlement usually require that the debtor pay off the debt in a lump sum. If the debtor had the money to pay off the debt they probably would have paid it. Since the debtor doesn’t have the money he has to save it over time, and during this time the debtor’s remaining debts are nevertheless accruing interest, so that once the original claim is settled the remaining debt has continued to grow so that the debtor hasn’t reduced the amount nevertheless owed.

There are some instances when debt settlement may work, but for most people the math simply doesn’t work. Before settling a debt it is a good idea to seek help from a specialized with experience in financial issues. Bankruptcy attorneys often represent debtors in other types of financial matters, such as loan modifications and debt settlement, so they may be a good advisor on these types of matters. An accountant may also be able to advise you whether your budget can be modificated to make paying off the debt possible.

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